Welfare reform in European countries: a microsimulation analysis

This paper estimates the welfare and distributional impact of two types of welfare reform in the 15 (pre-enlargement) member countries of the European Union. The reforms are revenue neutral and financed by an overall and uniform increase in marginal tax rates on earnings. The first reform distributes the additional tax revenue uniformly to everybody (traditional welfare) while the second reform distributes tax proceeds uniformly to workers only (in-work benefit). We build a simple model of labor supply encompassing responses to taxes and transfers along both the intensive and extensive margin. We then use EUROMOD to describe current welfare and tax systems in European Union countries and use calibrated labor supply elasticities along the intensive and extensive margins to analyze the effects of the two welfare reforms. We quantify the equity-efficiency trade-off for a range of elasticity parameters. In most countries, because of large existing welfare programs with high phaseout rates, the uniform redistribution policy is undesirable unless the redistributive tastes of the government are extreme. The in-work benefit reform, on the other hand, is desirable in a very wide set of cases. We discuss the practical policy implications for European welfare policy.